Monday, November 27, 2006

ENER - Review

Here's a position on ENER that closed in January. The following is the trade history and returns, including IB commissions. This position was established before I changed my return and stock selection criteria.

09/19/05 - Bought 100 shares @ 37.92
09/19/05 - Sold 1 Oct05 35 Call @ 3.99
10/21/05 - Oct05 35 Call expired
10/24/05 - Sold 1 Nov05 35 Call @ 1.74
11/18/05 - Nov05 35 Call expired
11/23/05 - Sold 1 Dec05 35 Call @ 0.49
12/16/05 - Bought 1 Dec05 35 Call @ -0.71
12/16/05 - Sold 1 Jan06 35 Call @ 2.74
01/20/06 - Jan06 35 Call exercised and stock called away

Stock Investment: $3,792.00
Income Generated: $825.00
Net Profit: $533.00
Percent Return: 14.06%
Annualized Return: 41.71%
Duration of Trade: 123 days

Buy & Hold Comparison

Opening Price: $37.92
Closing Price: $54.44
Dividends: $0.00
Net Profit: $1,652.00
Percent Return: 43.58%
Annualized Return: 129.31%
Duration of Trade: 123 days

This is a good example of a position that would have done better with buy & hold. If you look at a chart of ENER you'll see that the stock declined shortly after the initial purchase and then recovered. At one point, in Dec05, it traded as low as $28.76, or down about 24%.

The first two months the options expired worthless as the stock declined. The Dec option was bought back and rolled out to January. The stock shot up from Dec until Jan expiration, where the call was exercised and the stock was called away.

The profit on this trade was well above my goal of 24% annualized, and therefore I let the stock get called away. As stated above, I would have done much better with a buy & hold strategy. However, I don't worry about that. Hindsight is 20/20. I set a goal and exceeded it, so I'm satisfied with the return.

I go for base hits, not home runs. Sure, everyone loves home runs, but they don't happen very often. Look at the batting average of most home run hitters, they strike out a lot, but when they hit a home run everyone cheers. However, it's the guys that consistently get base hits that have the best batting averages and help win ball games. With bases loaded, every base hit scores a run.

Saturday, November 25, 2006

SWFT - Review

Here's a position on SWFT that closed in July. The following is the trade history and returns, including IB commissions. This position was established before I changed my return and stock selection criteria.

05/27/05 - Bought 200 shares @ 24.91
05/27/05 - Sold 2 Jun05 25 Calls @ 0.74
06/17/05 - Jun05 25 Calls expired
06/20/05 - Sold 2 Jul05 25 Calls @ 0.24
07/15/05 - Jul05 25 Calls expired
07/18/05 - Sold 2 Oct05 25 Calls @ 0.79
08/25/05 - Bought 2 Oct05 25 Calls @ -0.11
09/23/05 - Sold 2 Oct05 17.50 Calls @ 0.59
10/21/05 - Bought 2 Oct05 17.50 Calls @ -0.21
10/25/05 - Sold 2 Nov05 20 Calls @ 0.19
11/14/05 - Bought 2 Nov05 20 Calls @ -0.66
11/23/05 - Sold 2 Jan06 22.50 Calls @ 0.44
01/19/06 - Bought 2 Jan06 22.50 Call @ -0.61
01/19/06 - Sold 2 Apr06 25 Calls @ 1.04
03/24/06 - Bought 2 Apr06 25 Calls @ -0.16
03/24/06 - Sold Jul06 25 Calls @ 0.89
07/21/06 - Apr06 25 Calls exercised and stock called away

Stock Investment: $4,982.00
Income Generated: $637.00
Net Profit: $655.00
Percent Return: 13.15%
Annualized Return: 11.43%
Duration of Trade: 420 days

Buy & Hold Comparison

Opening Price: $24.91
Closing Price: $26.54
Dividends: $0.00
Net Profit: $163.00
Percent Return: 6.55%
Annualized Return: 5.69%
Duration of Trade: 420 days

This is a good example of a position that was recovered using rolling strategies. If you look at a chart of SWFT you'll see that the stock declined shortly after the initial purchase and then recovered. At one point, in Sep05, it traded as low as $16.25, or down about 35%.

In Sep05, after the stock dropped to its lowest point, the 25 calls were rolled down to 17.50. But then the stock started to recover and those calls had to be bought back and rolled up to 20. Then the 20 calls were bought back and rolled up to 22.50. And finally the 22.50 calls were bought back and rolled up to 25. The 25 calls were exercised in Jul06 and the stock was called away. Again, I allowed the stock to be called away because I no longer wanted to hold it.

This position did better than buy & hold, which only had a 5.69% annualized return. Even though the stock was down 35% at one point, again, rather than sell at a loss, the position was managed to a profit. Again, notice that the income generated was received long before the stock was called away and was able to be reinvested into other positions.

Friday, November 24, 2006

PPC - Review

Here's a position on PPC that closed in September. The following is the trade history and returns, including IB commissions. This position was established before I changed my return and stock selection criteria.

09/19/05 - Bought 100 shares @ 35.17
09/19/05 - Sold 1 Oct05 35 Call @ 1.19
10/21/05 - Oct05 35 Call expired
10/24/05 - Sold 1 Nov05 35 Call @ 1.99
11/18/05 - Nov05 35 Call expired
11/23/05 - Sold 1 Jan06 35 Call @ 0.64
12/30/05 - Dividend received @ 0.02
01/13/06 - Dividend received @ 1.00
01/20/06 - Jan06 35 Call expired
01/23/06 - Sold 1 Mar06 30 Call @ 0.19
02/21/06 - Bought 100 shares @ 23.92
02/21/06 - Combined Cost Basis @ 29.55
02/21/06 - Sold 1 Mar06 30 Call @ 0.04
03/17/06 - Mar06 30 Calls expired
03/20/06 - Bought 100 shares @ 22.18
03/20/06 - Combined Cost Basis @ 27.09
03/20/06 - Sold 3 Sep06 25 Call @ 1.44
03/31/06 - Dividend Received @ 0.02
06/30/06 - Dividend Received @ 0.02
09/15/06 - Sep06 25 Calls exercised and stock called away
09/29/06 - Dividend Received @ 0.02

Stock Investment: $8,127.00
Income Generated: $958.00
Net Profit: $331.00
Percent Return: 4.07%
Annualized Return: 4.12%
Duration of Trade: 361 days

Buy & Hold Comparison

Opening Price: $35.17
Closing Price: $27.68
Dividends: $108.00
Net Profit: -$641.00
Percent Return: -18.23%
Annualized Return: -18.43%
Duration of Trade: 361 days

This is a good example of a position that was recovered by dollar cost averaging. If you look at a chart of PPC you'll see that the stock declined shortly after the initial purchase and never recovered. At one point, in Mar & Apr, it traded as low as $20.94, or down about 40%.

Rather than panic and sell at a loss, I used dollar cost averaging twice during this holding period to lower the cost basis of the stock, which allowed me to get out at a profit. I allowed the stock to get called away since I no longer wanted to hold this stock.

Notice that the stock was called away at a price ($25) that was 29% below the original purchase price ($35.17). By lowering the cost basis with dollar cost averaging the stock doesn't have to recover back to the original price. Also notice that $958 of income was generated during this period, which was reinvested in other positions.

The annualized return on this position wasn't great, in fact I could have done better in a money market account. However, it beat buy & hold, which was down over 18% annualized. Sure I probably could have done better with a different stock, by the point here is that I didn't lose money. Sometimes positions don't work out, but if managed properly you can still preserve your capital and come out ahead.

Tuesday, November 21, 2006

Trade Selection

For stock selection, I basically use the methods described in Pat Dorsey's book "The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market". Mr. Dorsey is the Director of Stock Analysis at Morningstar. This is a value investing approach. I look for companies that generate positive earnings, free cash flow, have good return on equity and low debt. I use Morningstar to find these companies and then run the stocks through Value Line Daily Options Survey (I previously used PowerOptions) to find potential covered call trades.

Here is an example of the thought process I go through when selecting and analyzing trades.

This is an excerpt from a Yahoo discussion regarding a proposed WFMI trade on 11/2, where the stock dropped about 23% the following day after an earnings announcement.

First of all, establishing a covered call trade on or near the day of earnings announcement is risky. It's better to wait until after the announcement to see how the stock reacts.

With that said, let's assume that a position was established on 11/2 using closing prices of that day per OptionsXpress Historical Quotes:

Buy 100 WMFI at $60.13
Sell 1 Dec06 50 Call at $11.59

Stock Investment: $6,013.00
Income Generated: $1,159.00
Percent Income Generated: 19.27%
Net Profit If Called: $146.00
Percent Return If Called: 2.43%
Annualized Return If Called: 20.61%
Days to Expiration: 43 days

The stock dropped $13.86 (23.10%) to $46.26. The break even is $48.54 so the above position is only down $2.28 (3.8%). And there's still 43 days until expiration, so the stock could recover back up to $50 and get called away for the expected profit.

This is just an example and not necessarily what I would have done, but it just shows that it was possible to put on this trade and still make out ok.

Here's how I would have analyzed this trade.

First I start with the company. WFMI is a good solid company. They've had increasing sales revenue and earnings per share for the past 10 years. They've generated free cash flow for the past 5 years. Their return on equity has averaged about 14% per year over the past 10 years. They have a very low debt/equity ratio. And they pay a dividend, which currently yields 1.3%. So, in my view this is a good stock to own for the long term.

Then I read the Morningstar analyst report and compare the stock price relative to the fair value. I try to find companies that are trading at a discount to their fair value. If a stock is overpriced I usually skip it. In this case this stock was undervalued according to Morningstar.

Next I would see if the cost of the stock is within my position sizing limit, which is 5% or less of total capital. So, for example, if I had $100,000 total capital, that limit would be $5,000 per stock position. In this case the total stock cost, including commissions, is $6,013, which is over the limit so I probably would not have placed this trade.

If the stock is within my position sizing limit, I would then look at the options to see if I could place a covered call trade that meets my return and downside protection criteria. For this example I used SysCW's criteria of 15%/15%.

If the trade has passed all of the above I then look at news and company events. I probably would not have placed this trade on this particular day since earnings were going to be announced after the market close. I would have waited a few days to see how the stock reacted.

Now, let's assume I ignored some of my rules and established this position anyway on 11/2. The stock is down about 23%, trading at $46.26, which is below the strike price of $50 with 43 days until expiration.

Now, since I've already determined that WFMI is a good long term stock, I would not close the position and take my loss. I would hold out until expiration. If the stock recovers and closes above $50 I would make my expected return. If not, I would sell another call at that time and may dollar cost average to pick up more shares at a better price.

Update as of 11/21: WFMI is trading at $49, within $1 of the strike price with 24 days before expiration, so it looks like this trade just might work out.

The key is in the stock selection. I only choose stocks I'm willing to buy & hold, so when they drop I don't panic and sell at a loss. These are potential long term holdings. If I'm not willing to hold a stock I don't buy it.

In my opinion, the following 5 assumptions, as described in Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk (Financial Times Prentice Hall Books) by Michael Thomsett, are critical to successful covered call trading.

1. You will limit option activities to stocks you have pre-qualified.

2. You believe that your stocks will rise in value.

3. You accept the premise that fundamental analysis of stocks is an
essential first step in the process of examining options opportunities.

4. In the event of a temporary downward movement in a stock's price, you
would be happy to buy more.

5. You believe that there are an adequate number of available stocks that
meet your criteria.

Monday, November 20, 2006

Current Portfolio

Here's my current portfolio as of 11/20/06. There are 28 open positions with the majority of positions (21) having expiration dates in Jan07. So there won't be much activity for the next 2 months unless any adjustments are necessary. The average holding period for this portfolio is 327 days if all positions are held until expiration.


Stock

Opened

Expiration

DTE

KCI

08/01/05

12/15/06

501

KOMG

03/20/06

12/15/06

270

ARO

03/20/06

01/19/07

305

BJS

01/25/06

01/19/07

359

CECO

09/19/05

01/19/07

487

DHI

08/01/05

01/19/07

536

ELOS

03/20/06

01/19/07

305

EXP

04/24/06

01/19/07

270

EXPD

07/26/06

01/19/07

177

HLX

01/25/06

01/19/07

359

JBHT

02/21/06

01/19/07

332

NTES

03/20/06

01/19/07

305

NTY

10/24/05

01/19/07

452

NVDA

04/24/06

01/19/07

270

NVT

10/24/06

01/19/07

87

OSUR

03/20/06

01/19/07

305

PSUN

11/21/05

01/19/07

424

RMBS

04/24/06

01/19/07

270

SHW

02/21/06

01/19/07

332

SNDK

04/24/06

01/19/07

270

STLD

04/24/06

01/19/07

270

WGO

07/19/05

01/19/07

549

ZMH

02/22/06

01/19/07

331

BBBY

11/21/05

02/16/07

452

PALM

04/24/06

02/16/07

298

XXIA

03/20/06

02/16/07

333

ISE

11/20/06

04/20/07

151

MA

11/20/06

04/20/07

151

 

 

Today's New Positions

As previously posted, two new positions were established today on ISE and MA. Both are solid companies with positive earnings, good return on equity, and low debt. Both are trading slightly above their fair value according to Morningstar. While I try to find companies trading at or below their fair value, sometimes these are hard to find. My main concern is the company's financial health and both of these companies are in great shape.

Both positions have 5 months until option expiration. The potential profit if called has already been received and can either remain in the account to collect interest or be invested into other positions.

Now, unless there's a significant price change between now and April 2007, I'll just sit back and wait until option expiration.

MA - New Position

A new position was established this morning on MA. The following is the trade information, including IB commissions:

11/20/06 - Bought 100 shares of MA @ 95.27
11/20/06 - Sold 1 Apr07 95 Call @ 11.50

Stock Investment: $9,527.00
Income Generated: $1,150.00
Percent Income Generated: 12.07%
Net Profit If Called: $1,123.00
Percent Return If Called: 11.79%
Annualized Return If Called: 28.49%
Days to Expiration: 151 days

ISE - New Position

A new position was established this morning on ISE. The following is the trade information, including IB commissions:

11/20/06 - Bought 100 shares of ISE @ 51.81
11/20/06 - Sold 1 Apr07 50 Call @ 7.59

Stock Investment: $5,181.00
Income Generated: $759.00
Percent Income Generated: 14.65%
Net Profit If Called: $578.00
Percent Return If Called: 11.16%
Annualized Return If Called: 26.97%
Days to Expiration: 151 days

Friday, November 17, 2006

NBL - Closed

The NBL Nov06 45 Call closed ITM today and the stock will be called away for a profit. The following is the trade history and returns, including IB commissions. The initial trade returned 3% cash back and was before I switch to longer term options with 12%+ cash back in March.

01/23/06 - Bought 200 shares of NBL @ 44.41
01/23/06 - Sold 2 Feb06 45 Calls @ 1.49
02/17/06 - Feb06 45 Calls expired
02/21/06 - Dividend received @ 0.05
02/24/06 - Sold 2 Mar06 45 Calls @0.69
03/17/06 - Mar06 45 Calls expired
03/20/06 - Sold 2 May06 45 Calls @ 0.99
05/19/06 - May06 45 Calls expired
05/22/06 - Dividend received @ 0.075
05/23/06 - Sold 2 Nov06 45 Calls @ 3.69
08/21/06 - Dividend received @ 0.075
11/17/06 - Nov06 45 Calls exercised and stock called away
11/20/06 - Dividend received @ 0.075*

*Dividend was paid on 11/02/06 and is expected to be received next week.

Stock Investment: $8,881.00
Income Generated: $1,429.00
Net Profit: $1,548.00
Percent Return: 17.43%
Annualized Return: 21.35%
Duration of Trade: 298 days

Buy & Hold Comparison

Opening Price: $44.41
Closing Price: $49.15
Dividends: $55.00
Net Profit: $1,002.00
Percent Return: 11.27%
Annualized Return: 13.81%
Duration of Trade: 298 days

If you look at a stock chart for NBL you'll see that during this trade NBL was up and down. At one point, in June while I was on vacation, it was down over 18%, a new 52 week low. Then it shot up to a new 52 week high in August. It went down again to around $42 in late September and early October, and finally climbed to where it closed today.

This trade had a larger profit than buy & hold. Also, with buy & hold the profit isn't received until the position is closed, except for dividends of course. With the covered call trade most of the profit was received long before the position was closed. That money could then remain in the account to collect interest or be invested in other positions, thereby earning even more money.

A Bit of History

I started this covered call portfolio in May 2005. In the beginning I sold front month options with the goal of making 2-3% return per month. I didn't pay much attention to fundamentals, at that time, except for Altman's Z-score, which measures the likelihood of a company going bankrupt. I also didn't use a value investing approach. As such, some of the stocks I purchased were overvalued from a value investing standpoint.

In March 2006, after hearing about Systematic Covered Writing, which teaches a covered call methodology, I switched from selling front month options to longer term options, mostly ITM, returning 12%+ cash back and 24% annualized if called. This brought in more income in April and pushed out the expiration dates by about 3 months or more. So, rather than bringing in 2% in April, I brought in 6%, or about 3 months worth of income in a single month. This meant that I could bring in zero income for the next 2 months and still have an average income of 2% per month. It also meant less trading each month.

During May-July the market declined and many of my positions were underwater. I went on vacation the entire month of June and never checked my portfolio. When I returned, a few stocks were called away and I had cash to invest in new positions. However, since several positions were down I needed to use some of the money to recover them by dollar cost averaging.

May 2006 completed 1 year of trading covered calls and, when I returned from vacation in July, I reviewed my trading plan. Although I had met my goals I was concerned about the number of positions that were down. I modified my stock selection criteria to concentrate more on fundamental analysis and use a value investing approach, with the goal of reducing the risk of a major stock decline or company bankruptcy. It's too early to tell what difference this has made since I've only added a couple of new positions since making this change.

I only trade about once a month, during the week of or following option expiration. Each month I replace any stocks that are called away and make adjustments to existing positions. Starting next week, I'll post any new positions I establish and update them through closure.

Wednesday, November 15, 2006

Covered Call Trading Plan

Version 14 - Updated 01/02/14 (see History)

INVESTMENT OBJECTIVES

The primary objective is to generate 1% of income per month on invested capital.

Results will be based on invested capital only and the monthly averages will be used to determine the annual return.

Investments will be made in a diversified portfolio of common stocks in dividend paying companies and a limited number of ETF's.

INVESTMENT STRATEGY

The primary strategy is to establish positions in undervalued companies with solid fundamentals, and a history of increasing dividends (see Stock Selection below). Positions may also be established in a limited number of ETF's.

Cash Secured Put (CSP) options will be sold to establish new positions and Covered Call (CC) options may be sold once the stock is acquired.

The income generated will be reinvested, held in cash, transferred to other accounts or used for other investment strategies, depending on the availability of qualified candidates and/or other investment opportunities.

POSITION SIZING

Initial positions will be established at 100 shares.

Additional shares of a given company may be purchased, usually through the assignment of put options.

All positions will be managed separately, regardless of the company. There may be multiple positions in the same company.

ASSET ALLOCATION

This portfolio will use two asset classes as follows:

  • Individual Stocks.

  • Exchange Traded Funds.

When few opportunities are available, more cash may be held in the account, transferred to another account, or used for other investment strategies.

STOCK SELECTION

The following resources will be used to select potential candidates:

The following is the selection criteria for Dividend Champions:

  • Dividend Champions (25+ years), Contenders (10-24 years), or Challengers (5-9 years).

  • No Master Limited Partnerships (MLP's).

  • Covered by Morningstar and Value Line Daily Options Survey.

  • Morningstar (M*) rating >= 3 stars.

  • Strike Price below M* Fair Value.

  • Return on Investment (ROI) >= 1%

The following is the selection criteria for ETF's:

  • CSP downside protection of 5% or greater.

  • Return on Investment (ROI) >= 1%

ENTRY/MAINTENANCE STRATEGY

Initial positions will be established by selling a CSP below the fair value and current stock price.

If the CSP is assigned, CC's may be sold at/above the purchase price until the stock reaches fair value or is called away.

Stocks may be also held uncovered to take advantage of capital appreciation opportunities.

EXIT STRATEGY

When a company's fundamentals no longer meet the criteria, or if the company becomes overvalued and other qualified candidates are available, all positions for that company will be closed.

OPTION EXPIRATION STRATEGY

At option expiration, Cash Secured Puts (CSP), Covered Calls (CC) and Uncovered Stocks will be handled as follows.

Cash Secured Puts (CSP)

  1. If the company is no longer a qualified candidate, close the position.

  2. If the company is still a qualified candidate then do one of the following:

    • If assigned and the stock is purchased, continue the position by selling a CC at/above the purchase price. Try to avoid selling a call below the purchase price of the stock. The stock may also be held uncovered to take advantage of capital appreciation.

    • If expired and the same strike can be sold, continue the position by selling another put at the same strike.

    • If expired and the same strike can not be sold, close the position.

Covered Calls (CC)

  1. If the company is no longer a qualified candidate, close the position.

  2. If the company is still a qualified candidate then do one of the following:

    • If assigned and the stock is sold, close the position.

    • If expired and the same strike can be sold, continue the position by selling another call at the same strike.

    • If expired and the same strike can not be sold, hold the position uncovered until the same or higher strike can be sold. Try to avoid selling a call below the purchase price of the stock.

Uncovered Stocks

  1. If the company is no longer a qualified candidate, close the position.

  2. If the company is still a qualified candidate then do one of the following:

    • Continue to hold the stock uncovered.

    • Sell a CC at/above the purchase price. Try to avoid selling a call below the purchase price of the stock.